Goldman’s contingent callable notes tied to three indexes show impressive, hard to get coupon

By Emma Trincal

New York, June 9 – GS Finance Corp.’s callable contingent coupon notes due July 2, 2018 linked to the least performing of the Russell 2000 index, the S&P 500 index and the Euro Stoxx 50 index offered an above-average coupon rate, but the conditions necessary to receive it as well as the risks associated with the structure made advisers hesitant if not disinclined to consider the trade.

Unusual observation

The innovative part of the structure was the inclusion of a coupon barrier based on an American option, they noted.

American options can strike any time prior to expiration by opposition to European options, which are exercised only at the end of the term.

In this case, the notes will pay a contingent quarterly coupon at an annual rate of 14.25% if each index closes at or above 75% of its initial level on every trading day during that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be guaranteed by Goldman Sachs Group, Inc.

The notes are callable at par plus the contingent coupon on any coupon payment date.

At maturity, the 75% threshold turns into a European barrier. Investors receive par if the final value of the worst index is at or above 75% of its initial price. If not, investors will be fully exposed to any losses of the worst-performing index.

Big coupon

Steve Doucette, financial adviser at Proctor Financial, examined the pros and cons of the product, noting that the coupon was high for a reason. He was hesitant to decide whether he would be inclined to consider the notes as the risk was high.

“That’s a heck of a coupon, “he said.

“But the reason why it is high is because you’re looking at a non-European barrier that’s observed any day during the quarter.

“Knowing how volatile the markets are I can’t be comfortable with an American barrier. The American barrier scares me. But it’s a very attractive coupon.”

Worst of

Other risk factors or hard-to-meet conditions other than the American coupon barrier drove the high return, he said. The first one was the discretionary call on any quarterly date. The second was the worst-of payout, which adds more risk when the underlying indexes are not perfectly correlated, he noted. Finally in this case, three indexes are used instead of two, making the likelihood of a barrier breach even greater.

Breaking down market risk into two parts – the risk of losing principal at maturity and the risk of not getting paid, Doucette noted that at least the barrier at maturity was set point to point.

“The American barrier is only there for the coupon,” he said.

“The big question is still what you get at maturity. The worst-of is still in place. At the end of the notes are you willing to be long the worst index?”

Back to the drawing board

Looking at the risk of not receiving any coupon, Doucette was a little bit more optimistic while remaining cautious.

“You might collect six out of eight if the market drops and comes back,” he said.

“Still I don’t like that you can easily lose this coupon if any of the indexes are down on any day. You’re taking the worst-of risk.”

In order to invest in the notes, Doucette said he would have to further analyze the indexes and probably modify some of the terms.

“I’d have to evaluate what’s the likely worst index. Historically the Russell has always been the most volatile. The S&P has just reached new historical highs, but large-caps are less volatile than small-caps. Europe is still in recession, but the Euro Stoxx is fairly valued. I think the Russell is likely to have the most risk,” he said.

Doucette would probably want to negotiate the terms with the issuer in order to reduce the risk.

“We always want to outperform on the downside. We would probably want to give up some of the coupon,” he said. “If you shoot for 15% return you might be willing to take the risk. I am not. Since we’re eight years into the bull market, I would give up some of the coupon to lower the barrier.”

He mentioned for instance a lowering of the barrier to 60% from 75%.

“This would be an equity substitute and it offers a pretty good return. But I think as it is now, it’s risky,” he said.

Too creative

Matt Medeiros, president and chief executive of the Institute for Wealth Management, found little appeal in the notes.

“You have a great coupon, but in this case, I don’t think it’s worth the risk,” he said.

Yields have become so low that issuers are inclined to be more creative. He said he understood that trend.

“I like the idea to try to find ways to generate yield. Unfortunately in this scenario, I think the concept gets lost in translation. It gets too complicated and therefore, the potential for a coupon is diluted,” he said.

Unreliable

He also summarized the list of conditions making it harder for investors to get paid, such as the reference based on the lesser performing index, the requirement that no index drop more than 25% and the daily observation for the worst index observed on each new past quarter.

“When I’m looking for yield, I’m looking for dependability. If it’s based upon volatile indexes then I’m not comfortable with the idea that I may not receive my coupon,” he said.

“Daily observations add to the difficulty of getting paid.

“I’m trying to understand the rationale of this deal...That’s just a lot of moving parts that take away from the predictability and the ability to monitor the risk.

“I look at it as a mean to generate coupon. But I’m just not comfortable with the complexity.”

Goldman Sachs & Co. is the agent.

The notes will price on June 27 and settle on June 30.

The Cusip number is 40054KDW3.

© 2015 Prospect News.
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